Investing in China in a Trade War

The month of May has been a tough month for anyone invested in Chinese companies or any companies connected to China as the escalating trade war has punished those companies' stock prices far more than the rest of the market.  Sometimes this has been justified as the ongoing viability of the business is being affected by the trade war.  

This includes companies like Huawei and those companies who sell to Huawei.  In the indiscriminate selling however there has been a few companies who've been swept up through no fault of their own.  This kind of situation happens periodically and can be a great opportunity for value-oriented investors to buy a new company or to add to an existing position.

Normally I don't like discussing the stocks we buy publicly.  For one thing, our investment selections are proprietary, and they involve a lot of research and due diligence before we make the decision to invest.  Our clients pay us for that information and should be the sole benefactor of the information.  Another reason I usually hesitate to disclose our positions publicly is that if you publicly declare your opinion of a company, it makes it more difficult for you to change your mind in the future.  

The famous economist John Maynard Keynes is famous for saying, "When the Facts Change, I Change My Mind" and in investing it's always good to maintain a certain amount of flexibility in your decision making.  Sometimes when you make your opinion public though, your decision can be more entrenched and you become less flexible, which is not a good thing.

Despite those two reservations I decided it would be a good idea to speak to what's going on in the market given the relative silliness that is occurring right now. Clients may be nervously watching their Chinese positions come down on their statements, and without the proper understanding of why we own those companies, they will undoubtedly get nervous.  I hope this will help to alleviate some of those feelings our clients may have.

Most of our clients will have heard of the company Alibaba, though it is not as well known in North American circles as it probably should be.  Alibaba is a gigantic company worth just under $400 Billion (at present).  Alibaba is a Chinese technology company which is focused on E-Commerce, Business services and marketing (including cloud services and digital marketing), Financial services, and other complementary technology businesses.  The closest comparison in North America would be Amazon though for reasons I will explain shortly, Alibaba is a different type of business than Amazon.  

Alibaba's shares trade on the New York Stock Exchange in the US. Alibaba has a different business model than Amazon's e-commerce business in that Alibaba does not hold inventory itself.  Instead it charges a commission for third party retailers to sell using its platform. Because of this, Alibaba's e-commerce business has much higher margins than Amazon's does.  Alibaba achieved $13.8 Billion (USD) of free cashflow in 2018 on $36.2 Billion (USD) of revenue.  For comparison Amazon achieved slightly higher free cashflow of $17.3 Billion but needed much higher revenues of  $232.9 Billion to do it.  

This means Amazon is much less profitable than Alibaba at present.  In addition Alibaba is growing much faster than Amazon with Year over Year revenue growth of 51% as compared with 31% Year over Year revenue growth for Amazon.  In spite of this apparent advantage in profitability and growth, Amazon's stock is currently over 2.25 more expensive than Alibaba's stock.  Why is this?

Like all Chinese technology companies, Alibaba's share price has come down substantially as a result of the trade war, as well as the general slowdown of economic growth in China. In addition, there is increasing geopolitical concerns over Chinese technology companies with the potential banning of Huawei by the US Government and the possibility of further escalations on both sides. These go beyond traditional economic concerns as Huawei was banned for national security reasons.  These worries continue to drag on the price of all Chinese stocks, including Alibaba.  

As the negotiations continue to deteriorate, there is justified fears that the dispute will escalate out of control.  To make matters worse, China's economic growth is also slowing, though it remains pretty strong at 6.6% in 2018. Notwithstanding this, Alibaba's business continues to power on, with a recently announced 1st quarter which beat analysts expectations, and with continued revenue growth of 51% year over year.  

In addition I think there are lots of good reasons why Alibaba's business will not be greatly affected by the trade war.  These include:

Reasons Alibaba will not Affected by the Trade War

Alibaba's revenues are almost entirely in China and Southeast Asia and very little comes from the United States.  As such they will not be affected by Tariffs to the US. They are actually a large importer of US and other international brands for sale in the Chinese market.  As any potential resolution of the trade war involves increasing Chinese imports, Alibaba is well positioned to take advantage of this.  

Alibaba is the platform of choice for foreigners to sell in China. Alibaba is incentivized to ensure that the businesses that sell their products on its platform are treated fairly and that knockoffs are not available, and other intellectual property is not stolen or misused.  That is because their commercial relations with foreign companies depends on it.  This goes directly to one of the main US grievances in the trade negotiations.

The Chinese economy is shifting from an export led economy to a consumption driven economy.  That process, while it may be slowed by a trade war, will not be stopped by it.  This secular trend in China is very positive for Alibaba.

The middle class in China is over 300 Million people.  It is almost as large as the entire US population and is growing rapidly. It will double in the next ten years meaning there will be the equivalent of 2 US populations in China for Alibaba to sell to in the middle class alone. Total Chinese consumption is expected to grow from $5.5 Trillion USD today. It is also going to double in the next ten years.

Alibaba is not just a retailer as they are an e-commerce solutions provider.  Case in point is their partnership with Starbucks to increase Starbucks's digital footprint in China. This creates an online dimension for Starbucks's customer acquisition in China.  By harming Alibaba, the US would put at risk a lot of American companies who have partnered with Alibaba to do business in China.

The Chinese economy is already evolving to address the issues of concern by the American trade negotiators.  Although this does not address the national security concerns which have been raised in recent weeks, I think this is positive from an economic standpoint.  We may disagree on the pace of the Chinese evolution to Western standards of commerce, but fundamentally we agree that they should adopt western standards on these economic issues as it is to their own benefit.  

In any case Alibaba is in the best position of any company in China to benefit from these secular trends. The reason why Alibaba is well positioned, and the real strength in my conviction in investing in Alibaba comes down to its 4 moats which are as follows:

4 Moats

Alibaba is a large ecommerce platform providing scale and recognizability for Chinese consumers.  They have a huge market share of E-Commerce in China at almost 60% of the E-Commerce market which creates a loyal following of users. Alibaba supplements the value to these users by providing entertainment content through companies like Youku which provides original movies and televisions shows to Chinese consumers just like Netflix in North America.  Alibaba also has subsidiaries in music, gaming, and literature which serve as complementary entertainment sources for Alibaba's customers.  By doing this they encourage consumers to continue using Alibaba.

Alibaba's Business Operating System business encourages product and service providers to sell their wares through Alibaba's platform.  These services include Logistics, Cloud, Financial Services, and Retail/Marketing services.  Aside from the quality of these business operating services, businesses are incentivized by Alibaba's large userbase to utilize Alibaba's Business Operating System in order to gain access to the consumer userbase. In turn the userbase is incentivized by the vast product selection offered by the business customers of Alibaba.  As these two businesses increase in size, the incentives become stronger.

The third moat is Alipay.  Alipay is the payments service which is dominant in China along with its competitor Wepay.  In North America it would be comparable to Paypal or more traditional payments providers like Visa or Mastercard.  As the consumer userbase and the number of business clients grow, it is only natural for them to gravitate towards Alipay as their method of choice for payments.  This creates another moat around the businesses as there would be switching costs to use a different payment system.  Consumers can also be incentivized through rewards programs, which would make Alibaba's users less likely to switch to a competitor. Consumers may also start to utilize other financial services available from ANT Financial which would further increase their reliance on Alibaba.

Finally the fourth moat.  The large userbase of consumers and businesses, gives Alibaba data.  Alibaba can use this data to more effectively market its products and services as well as itself to potential customers.  This increases their effectiveness (and profitability) of their digital advertising.  As their userbase increases, this data advantage increases.  This makes Alibaba more useful and will make their customers more satisfied with Alibaba as the provider.  This increases the attractiveness of Alibaba as the business solutions provider as well and reinforces moats 1, 2, and 3 above.

These four moats are growing and are self-reinforcing.  In this way they create a network effect that gets stronger the bigger Alibaba gets.  I prefer Alibaba's model to Amazon's in fact because their model doesn't pit Alibaba as a competitor to the other retailers.  Instead Alibaba has positioned themselves as a partner of the retailers. This has tremendous advantages both for retailers and for Alibaba.  

Amazon in fact seems to be moving more towards this type of model themselves (Amazon is poised to unleash long feared purge of small suppliers), perhaps seeing the merits of this model. Even if they want to move to that kind of model though, Amazon will not be able to do so without significant transition pains.  I think it's unlikely that Amazon will ever move completely to Alibaba's model, and that is an advantage for Alibaba.

The trade wars and national security issues with China are a difficult issue to resolve. However I think the rhetoric has been at peak hysteria over the past couple of weeks. It is also useful to compare Alibaba to Huawei to see if a similar fate could befall Alibaba with the US government.  For one thing if Alibaba were to be banned in the US, it would not greatly affect their business directly because as I mentioned, very little of their revenue comes from the US. It would require Alibaba to source equipment and components for their business from non-US technology companies, however this would likely be doable (not to mention it would hurt those US suppliers).

With respect to access to financial services, Alibaba is looking at a second offering in Hong Kong which would allow Alibaba to be less dependent on the US for finance. This will be a boon to Alibaba shareholders. It's also unlikely that Alibaba would be subject to treatment like Huawei because there is no comparable national security concerns with Alibaba as there are for Huawei. Alibaba does not produce equipment which could be used as surveillance devices on Americans.  

In addition, while Huawei is a privately held company which is owned exclusively by Chinese people, Alibaba is a publicly traded company which has many American and other western shareholders.  The Co-founder Joseph Tsai is a Canadian citizen who was born in Taiwan and lives in California.  In the top 10 largest shareholders of Alibaba there is, Altaba, Blackrock, T. Rowe Price and Associates, Baillie Gifford and Co, SoftBank Group, Capital Research and Management Company, Vanguard Group, and State Street Corporation, all of which are American with the exception of Softbank (Japanese) and Baillie Gifford (UK).

All of these owners are financial services companies or publicly traded companies which would have many retail investors.  So if the US was to block Alibaba shares from trading, they would be hurting millions of Americans by doing so.  I think this is unlikely even with Donald Trump as the president.  While it's very possible that politicians in the US and China will continue to act rashly in the short term, in the long term I think there is too much at stake for them not to come to a deal which is tolerable for both countries.  

For that reason, I believe cooler heads will prevail, and our investment in Alibaba will reward us handsomely for our fortitude in weathering these temporary storms in the market. If anyone does have questions on this investment, or any other position in their portfolio I would encourage you to reach out to me.

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at the award winning firm Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.